An insurance advisor once gave me a limerick: The cost of insurance was such that I unfortunately couldn’t touch its price, so I declined the offers, then filled the coffers from the government, and now it costs three times as much. I thought it was a valiant attempt to sell me a policy.
If you are going to invest in an insurance policy, you need to understand what you are accomplishing with the insurance. There may be more than one answer. Consider these top 10 uses of life insurance.
1. Provide for dependents. If you had left tomorrow, would the loss of your income cause financial hardship for your dependents? If so, life insurance can fill the void by providing money to invest to generate income. This is especially useful if you are rich in assets, but those assets are illiquid (like real estate or a business). Unless these assets produce sufficient income or can be easily sold to free up cash, your dependents may otherwise struggle to earn the ends meet.
2. Funding for specific purposes. When insurance pays, it can help fund specific goals, such as paying for a child’s education, providing a fund to help children cover the annual costs of maintaining the family cottage, providing a pet, or cover your funeral expenses.
3. Build retirement savings. It is possible to accumulate investments in an insurance policy on a tax-sheltered basis and then access these funds in retirement or for other purposes, either by making withdrawals from the policy or by borrowing against the policy as collateral. See my article last week for an example.
4. Equalization of inheritances. Suppose you have specific assets that you want to bequeath to specific children or heirs when you die. It may be a valuable cottage, business, or jewelry that you want a particular person to have. If you want to bequeath an equal amount to each of your heirs, leaving money – perhaps insurance proceeds – to other heirs can be a great way to equalize inheritances.
5. Repay debts. Ensuring that your personal or business debts are paid off when you die can be of great help to your heirs or business partners. Insurance can provide the cash needed to pay off these debts. If you don’t take care of these debts, creditors – including the Canada Revenue Agency in the case of tax debts – could have recourse to recover the property that you will leave to your heirs after you leave. By the way, the mortgage loan insurance offered by your bank, to pay off your mortgage if you die, is very expensive insurance. As your mortgage balance decreases, the cost of this insurance remains constant. Instead, consider taking out a term insurance policy to pay off your mortgage.
6. Covering taxes due. Take the time to calculate the taxes that will be due on your death and the death of your spouse. How will these taxes be paid? Make sure you can answer this question. If you and your spouse bequeath assets to each other when you die, taxes will be deferred until the death of the second spouse. In this case, consider a joint last-to-die policy on the lives of both spouses to cover taxes. The insurance won’t pay out until the second death, so the policy is cheaper than a single life one.
seven. Abolition of taxes on death. There are strategies using insurance that can eliminate taxes at death. You could, for example, insure the life of your children. This will allow you to accumulate investments in these policies. You can then transfer ownership of the policies to your adult children tax-free upon your death, or at any time, effectively transferring the investments in the policy to your children tax-free. This transfer could otherwise be taxable if the investments were outside of a policy.
8. Donate to charity. You can make a significant gift to your favorite charity when you die by having life insurance proceeds donated to the charity. You can name a charity as the beneficiary of a policy, transfer ownership of a policy to charity, have your estate donate insurance proceeds, or purchase a policy for charity . Each idea has different tax implications. See my November 18, 2021 post for more.
9. Financing of a buy-sell agreement. If you own a business with partners, what will happen when one of you dies? Many shareholder agreements allow a surviving partner to buy out the deceased partner’s share upon their death. Insurance can provide the money needed to finance this purchase.
ten. Ensure the protection of key people. If your business were to be adversely affected by the death of a key business person, consider purchasing life insurance for that person. If they die, the business will receive insurance proceeds which can help in a transition period.
So, it turns out there may be more truth to this limerick after all.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is author, co-founder and CEO of Our Family Office Inc. He can be reached at [email protected].